Last September, less than two weeks after an IPO plan was approved, the private equity owners of India's Lilliput Kidswear got a call that set off a chain of events that could wipe out their investment.

According to sources with knowledge of the matter, an anonymous caller phoned Lilliput's accountants on Sept. 22 with information that revenue figures might be inflated.

The next day, executives at the Mumbai offices of private equity firm Bain Capital got the same call. They quickly told their partners in Lilliput, TPG Capital.

What followed is an ordeal symbolic of both India's rapidly sagging private equity market and a reminder of the perils that await foreign investors there.

It also highlights the broader souring of hopes for India, where policy paralysis, corruption scandals, flagging growth and high inflation have sapped investor confidence, prompting net foreign fund outflows of $540 million in March and April.

Bain and TPG have accused India's largest kidswear company of accounting fraud, in a case filed with the Delhi High Court.

The court in November appointed SS Kothari Mehta & Co. to conduct an independent audit of Lilliput's accounts, but the report remains incomplete.

Lilliput's founder, Sanjeev Narula initially cooperated with the audit but then stopped, according to court documents, saying the probe went too far. At a High Court hearing on Wednesday, the court ordered that the audit dispute be settled by an arbitration tribunal.

While details of the case are unique, including accusations of threatening text messages and inciting protests, the failure of an Indian entrepreneur to successfully team up with a Western private equity group is common in Asia's third largest economy.

The dollar figure involved for the private equity firms, which oversee around $110 billion combined, is not large. Bain invested $60 million and TPG put up $26 million for the 45 percent Lilliput stake, which sources familiar with the matter say the two firms have written down to zero as the company teeters on the brink.

What's at stake for Bain and TPG is their reputation in India, with Narula accusing the firms of crippling the company.

For the Indian private equity market the danger is that, should an accounting fraud be proven, it would be another red flag to investors, according to industry insiders.

RETURNS DISAPPOINT

The excitement of private equity opportunities in India, which reached fever pitch in 2007-2008, has crumbled.

"India has given almost zero returns in absolute terms in the past decade, despite high economic growth," said Anubha Srivastava, Asia managing director for CDC Partners, which has backed 24 private equity firms in the country.

In 2008, 49 private equity funds with a focus on India raised $13.9 billion, according to Preqin, an industry data provider. Last year the number of funds dropped to 27, raising just $5.3 billion.

For India specific funds, the number of companies invested in dropped to 38 last year from 155 in 2007, according to Thomson Reuters data.

The reasons for the drop are varied, industry players say, among them archaic rules that foreign investors thought would be updated but never were.

India's complex M&A rules effectively rule out leverage finance, which makes deals less profitable for foreign firms by discouraging them from borrowing money to make acquisitions, forcing them to use more cash.

The so-called "floor price" rule means that when a foreign investor puts money into a company it has to pay above the average price of the stock within a six-month range.

Private equity firms have a track record of job cutting and over-levering companies with debt. But they also have a record of success too, and in the case of foreign firms, they have much-needed capital to spend in a place like India, which could help fuel parts of India's lagging corporate sector.

That isn't happening, and now India's economic slowdown is only making the situation worse.

"India portfolios in the 2006-2008 cycle are probably worth, on average, around 40 to 50 cents on the dollar," said one Western private equity executive investing in India, who did not want to be named.

DUE DILIGENCE

Major buyout firms that flocked to Asia in the last five years saw opportunities in both India andChina. The China market was viewed as high risk and high reward, while India offered steady growth and a more transparent market.

With a few exceptions, India corporate governance was not viewed as a major hindrance for foreign private equity firms. But as the Indian economy slows, some worry that a few other cases of companies accused of cooking the books will go from a trickle to a stream.

"As things slow down, these things come more to the forefront," said Reshmi Khurana, India country head for Kroll, which specialises in due diligence for investors.

In the Lilliput case, sources close to Bain and TPG acknowledge that their due diligence failed to find irregularities prior to the investment.

The sources say the buyout firms were encouraged by the fact Lilliput had an independent board, a reputable auditor - the local affiliate of Ernst & Young, S.R. Batliboi & Co - and prior ownership by an established, large, local private equity firm.

A Feb. 6 letter sent to Lilliput and the independent auditors from the attorneys representing Bain and TPG says Lilliput sales may have been inflated and profits overstated, and "direct or indirect transactions with related parties may have been consummated for the purpose of furthering the irregularities".

Court documents also allege Narula organised a mob of as many as 100 demonstrators who went to the offices of Bain and TPG's lawyers in Delhi after the court battle surfaced, waving placards and shouting slogans, an incident captured on CCTV footage and filed with the High Court.

Narula has also sent "unsolicited and unwarranted text messages (SMSs) that contain oblique and hidden threats", the documents say.

Reached by phone, Narula denied the allegations and said the whole situation could have been resolved through face-to-face talks with Bain Capital.

"These things cannot be settled by the court. These things have to be sorted out between Bain and me," Narula said.

CHINA ALTERNATIVE

After some early success stories with firms such as Warburg Pincus, private equity appetite for India is fading. Investment returns have fallen far below expectations after a strong initial run in the mid-1990s to around 2004.

By comparison, returns from private equity investments in China in the last five years are, on average, more impressive.

"From 2004-2009, most investors have generated low single digit returns, compared to China which gave 20 percent," said CDC's Srivastava.

Bain and TPG, who declined to comment for this article, invested in Lilliput in March 2010.

Lilliput, based in New Delhi, makes and sells branded kidswear in India and exports finished goods to international companies including Gap Inc, Mothercare, Wrangler and Macy's.

According to sources, Bain and TPG's plan was to help the company expand production to tap the new middle class consumer in India's booming first and second tier cities, and boost exports to international markets at the same time.

Narula says total retail space at the company, grew from 220,000 sq ft to 800,000 sq ft in the 18 months after Bain and TPG invested.

The buyout firms' plan to grow the company appeared to have a positive start, and nearly resulted in an IPO, which the board approved just before the fraud allegations erupted.

Now, Lilliput's debt load - around $47 million according to a pre-IPO business plan seen by Reuters - coupled with the court battle that has resulted in bank credit lines being frozen since October last year, is strangling the company.

"We have shut down 25 shops because of financial strains, we have sacked around 10,000 people," said Narula. "Twenty years of my efforts have gone down the drain."

This article is copyrighted by Reuters